In the immortal words of songwriter Bob Dylan, "The times they are a-changin'."
Signs of change in the surety marketplace abound. Consider the liquidations
of Frontier Pacific and Amwest Surety, two active players in the small contract
surety market. At the other end of the spectrum you have AIG, now limiting their
focus to only jumbo net worth contractors. You have reinsurers, such as W.R.
Berkley, withdrawing or excluding certain classes of bonds from their reinsurance
treaties. You have some national carriers who are capping their participation
on large work programs. Then came the Fireman's Fund announcement that it was
exiting the surety market and selling its renewal book to a competitor.
What Changed?
Why is the surety marketplace changing and becoming more restrictive? With
significantly higher loss ratios for the surety industry last year and prospects
for still worse results ahead growing in large part out of the Enron debacle,
there is a move by both reinsurers and primary surety writers to return to more
consistent and fundamental underwriting standards. Surety premiums are a very
minor share of the revenue base for most insurers. The business, however, holds
significant exposure for large losses as the Enron case has again amply underscored.
The insurance companies who are the "parents" of most surety operations were
already suffering from effects of a prolonged soft market and the affects of
September 11. Therefore, if you are an insurance executive managing risk, you
may view the surety business as a low revenue business with a potential for
big losses. Your choices appear quite clear: exit the line entirely; restrict
your writings of this line; and/or implement sound underwriting standards. That
is what is happening and it very likely will affect your current bonding arrangements.
Easy Underwriting
Even without the Enron mess, the surety marketplace had become too "loosey-goosey."
It was almost as if anyone could obtain a bond regardless of experience, character,
or financial wherewithal. Such an environment may have generated additional
bond premiums for revenue hungry insurers, but it was also a disservice to the
many surety principals who earned their surety credit. It was also a disservice
to owners, general contractors, and other obligees that relied on the surety's
much advertised "prequalification" process. Therefore, bonding programs that
far surpassed the contractor's financial base or experience, the unwarranted
elimination of personal indemnity, or continually lower bond rates will come
to an end.
Self-Assessment
How should you deal with the changing marketplace? The first thing may be
to perform a self-assessment of sorts. Has your bonding credit grown at a much
faster rate than your financial base? Has the surety released the personal indemnity
of the owners? And/or have your bond rates decreased several times in the last
few years?
If the answer to one or more of these areas is "Yes," then you may expect
some change(s). To the extent that you earned each of these benefits, you should
work with your bonding agent and be prepared to support your entitlement. Surety
insurers want to continue their business relationships based on solid fundamentals,
and the burden will fall on you and your agent to demonstrate that you meet
those new standards.
The Relationship
What can you do to make your account more attractive to the surety underwriter?
Before addressing that question in more detail, I think there needs to be both
an understanding and an appreciation of the surety relationship and what exactly
the surety is doing when they write a bond for you.
The surety becomes your partner and is guaranteeing your contractual performance.
The surety is effectively putting its money where its mouth is. When it approves
your bond, it says to the world that it believes you have the capacity in every
respect to satisfactorily complete the bonded contract. Such a relationship
must have a foundation built on mutual respect and fair dealing. If viewed as
a partnership, then the responsibilities of the parties to each other become
quite clear.
Disclosure
To make yourself attractive to a surety requires in the first instance full
disclosure of your past and present operations, including any affiliated business
activities that can impact the operations and/or financial status of the entity
for whom bonds are to be provided. You have a pretty good idea of what events
will impact the financial result of a given project, and you know in the context
of your overall backlog how this may impact your company's financial results.
The surety does not want or need a day-to-day accounting on each job, but
if a major subcontractor defaults or there is a payment problem, it is probably
a material event that should be shared with your agent and the bond underwriter.
Bonding companies can deal with bad news, but what unnerves them are surprises.
The surety's approval of a particular contractor's project and/or overall
work program is made based on certain financial and operational parameters.
If those conditions change for any reason, the rules of fair dealing and the
partnership relationship require full and timely disclosure.
Recall that what really caused the downfall of Enron was its failure to provide
full and timely disclosure of its activities and financial position. That resulted
in a failure of confidence in a business that relied heavily on trust. Your
surety relationship is also based on trust, and if either party breaches that
by failure to fully and timely disclose relevant information, it destroys that
relationship. Bottom line: don't holdback or manipulate information. Neither
party should ever surprise the other. Good communication is essential.
Tangible Steps
With a tightening of the surety markets, what tangible things might you do
to improve both the relationship and your bonding line? You should begin by
retaining a professional surety bonding agent who will take the time to understand
your business and help you to communicate your story with an appropriate surety
market. You should retain a CPA who is active in the construction accounting
arena.
You also should preferably secure an annual certified audit with adequate
supporting schedules and footnotes that fully disclose and communicate your
operations and financial picture. Review level financial statements may still
be acceptable for smaller accounts, but my expectation is that sureties will
increasingly demand fully audited financial reports. Compilations or in-house
statements are of little or no value except perhaps for interim statements and
then only if they reasonably "mirror" the format of the CPA prepared statements.
Personal Indemnity
The issue of personal indemnity may become a discussion point. Depending
on the financial structure of your company relative to work program, how much
money the owners regularly take out in the form of salary and bonuses, the amount
of net worth outside the company, and/or the length and quality of your past
surety relationship all will bear on whether personal indemnity is appropriate.
Some sureties will consider a homestead rider that would exclude the indemnitor's
primary residence. Some may be willing to exclude specific assets, such as monies
inherited by the spouse. Some may consider a personal indemnity cap limiting
the financial exposure of a personal indemnitor. In the case of Sub-S entities,
the surety may consider a Net worth/Working Capital Maintenance agreement to
maintain a specific level of NW/WC in the corporation or personal indemnity
triggers.
Bank Line
Make sure you have a bank line of credit that will support your business
plan. While revolving bank lines create no working capital per se, they do provide
a facility to obtain cash to meet anticipated or unforeseen shortfalls in cash
flow. On a relative basis, contractors have always been considered more hazardous
than most other borrowers. Bank of America recently announced that they were
exiting all contractor bank lines of credit nationwide.
The number of banks willing to provide unsecured revolving line of credit
is also growing more limited. Nonetheless, the surety views an unsecured revolving
bank line as an important element in risk management. Without a bank line, the
surety may be one step closer to becoming your bank of last resort in the event
of a cash flow problem. Having a bank line is important for your fiscal management
and to enhance your relationship with the surety.
Cash Is King
Given that the economy has become more difficult, the ability to acquire
new profitable work may be more difficult, and the financial condition of owners
and subcontractors may be more difficult, you would do well to manage your business
to enhance your firm's working capital position. A contractor with a strong
net cash position may be able to fund problems without turning to third parties,
e.g., the surety or others.
The adage "Cash is king" becomes more true during difficult times. Therefore,
you may expect that with a tightening surety market, your working capital level
and balance sheet composition will receive more scrutiny.
Conclusion
If I were to summarize the foregoing points, I would say that the three essential
elements to a good working relationship with your surety are:
- Understand, appreciate, and support the surety relationship.
- Encourage open and timely communication with the surety.
- Effectively manage and mitigate the risks of your business.
Bob Dylan's lyrics, "The times they are a-changin'," are immortal because
change will always be with us. If you manage and effectively deal with these
changes, you will prosper and grow in both difficult and good times.